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The Impact of Consumer Confidence on Expected Utility Maximization: A Contribution to the Equity Premium Puzzle Literature

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Author Info
Vincenzo Merella (Department of Economics, Mathematics & Statistics, Birkbeck)
Steve Satchell (Department of Economics, Mathematics & Statistics, Birkbeck)

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Abstract

An omitted variable in the household's preferences specification may lead to overestimate the volatility of consumption, or alternatively to overvalue the risk aversion coefficient required to match the equity premium. This paper proposes to augment the utility function by adding a nontradable variable that is not under the consumer's direct control. We regard this variable as reflecting additional information on the household optimizing behaviour, and suggest two measures of consumer confidence as proxies for it. We find that the new specification of preferences eliminates the equity premium puzzle. In addition, we argue that the standard assumption of joint log-normality may not be supported by empirical evidence.

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File URL: http://www.ems.bbk.ac.uk/research/wp/PDF/BWPEF0525.pdf
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Paper provided by Birkbeck, Department of Economics, Mathematics & Statistics in its series Birkbeck Working Papers in Economics and Finance with number 0525.

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Date of creation: Dec 2005
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Handle: RePEc:bbk:bbkefp:0525

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